I am still in Provo Utah and even though I have had a busy time I have watch a bit of Bloomberg TV and CNBC over the last couple of days (to fight my jet lag). I have noticed some very puzzling comments from commentators. There have been one special theme and that has come up again and again over the last couple of days among the commentators on US financial TV and that is that “yeah, monetary easing might be positive for the markets, but it is not have any impact on the real economy”. This is a story about disconnect between the economy and the markets.

I find that perception very odd, but it seems like a lot of commentators simply are not mentally able to accept that monetary policy is highly effective. The story goes that when the Federal Reserve and the ECB moves towards monetary easing then it might do the markets good, but “real people” will not be helped. I find it unbelievable that well-educated economists would make such claims.

Markets are forward-looking and market pricing is the best tool we have for forecasting the future. When stock prices are rising, bond yields are rising, the dollar is weakening and commodity prices are going up then it is a very good indication that monetary conditions are getting easier and easier monetary conditions mean higher nominal GDP growth (remember MV=NGP!) and with sticky prices and excess capacity that most likely also mean higher real GDP growth. That has always been that case and that is also the case now. There is no disconnect between the markets and the economy, but there is a disconnect between what many commentators would like to see (that monetary policy is not working) and the reality.

To try to illustrate the connection between the markets and NGDP I have constructed a very simple index to track market expectations of future NGDP. I have only used two market indicators – a dollar index and the S&P500. I am constructed an index based on these two indicators – I have looked year-year percentage changes in both indices. I have standardized the indices and deducted them from each other – remember higher S&P500 means higher NGDP, but a stronger dollar (a higher USD index) means lower NGDP. I call this index the NGDP Market Indicator. The indicator has been standardized so it has the same average and standard deviation as NGDP growth since 1990.

As the graph below shows this simple indicator for future NGDP growth has done a fairly good job in forecasting NGDP since 1990. (You can see the background data for the indicator here).

During the 1990s the indicator indicates a fairly stable growth rate of NGDP and that is in fact what we had. In 1999 the indicator started to send a pretty clear signal that NGDP growth was going to slow – and that is exactly what we got. The indicator also clearly captures the shock in 2008 and the recovery in 2009-10.

It is obvious that this indicator is not perfect, but the indicator nonetheless clearly illustrates that there in general is no disconnect between the markets and the economy – when stock prices are rising and the dollar is weakening at the same time then it would normally be indicating that NGDP growth will be accelerating in the coming quarters. Having that in mind it is of course worrying that the indicator in the last couple of months has been indicating a relative sharp slowdown in NGDP growth, which of course provides some justification for the Fed’s recent action.

I must stress that I have constructed the NGDP market indicator for illustrative purposes, but I am also convinced that if commodity prices and bond yields and maybe market inflation expectations were included in the indicator and the weighing of the different sub-indicators was based on proper econometric methods (rather than a simple unweighted index) then it would be possible to construct an indicator that would be able to forecast NGDP growth 1-4 quarters ahead very well.

So again – there is no disconnect between the markets and the economy. Rather market prices are very good indicators of monetary policy “easiness” and therefore of future NGDP. In fact there is probably no better indicator for the monetary policy stance than market prices and the Federal Reserve and other central banks should utilize market prices much more in assessing the impact of monetary policy on the economy than it presently the case. An obvious possibility is also to use a future NGDP to guide monetary policy as suggested by Scott Sumner.

I am writing this while I am flying with Delta Airlines over the Atlantic. I will be speaking about the European crisis at a seminar on Friday at Brigham Young University in Provo, Utah.

I must admit that it has been a bit of a challenge to blog in recent weeks. Mostly because both my professional and my private life have been demanding. After all blogging is something I do in my spare time. So even though I wanted to blog a lot about the latest FOMC decision and the world in general I have simply not been able to get out the message. Furthermore – and this will interest many of my readers – Robert Hetzel and his wonderful wife Mary visited Denmark last week. Bob had a very busy schedule – and so did I as I attended all of Bob’s presentations in Copenhagen that week. Bob told me before his presentations that I would not be disappointed and that none of the presentations would be a “rerun”. Bob is incredible – all of this presentations covered different countries and topics. Obviously there was a main theme: The central banks failed.

I must admit after three days of following Bob and having the privilege to hear him talk about the University of Chicago in 1970s and his stories about Milton Friedman I simply had an mental “overload”. I had a very hard time expressing my monetary policy views – and the major policy turnaround at the Fed didn’t make it easier.

Anyway I feel that I have to share some of Bob’s incredible insight after his visit to Copenhagen, but I also feel that whatever I write will not do justice to his views.

So I have chosen a different way of doing it. Instead of telling you what Bob said in Copenhagen I will try to tell the story about how (a clever version of) New Keynesian economics and Monetarism could come to similar conclusions – and that merger is really Market Monetarism.

Why is that? I have for some time wanted to write something about a couple of new and very interesting, but slightly technical paper by Mike Belongia and Peter Ireland. Both Mike and Peter have a monetarist background, but Peter has done a lot work in the more technical New Keynesian tradition. And that is what I will focus on here, but I promise to return to Mike’s and Peter’s other papers.

Bob’s and Peter’s explanations of the Great Recession are exactly the same – just told within slightly different frameworks. Bob first wrote a piece on the Great Recession it in 2009 and Peter wrote his piece in 2010.

Peter and Bob are friends and both have been at the Richmond fed so it is not totally surprising that their stories of what happened in 2008-9 are rather similar, but I nonetheless think that we can learn quite a bit from how these two great intellects think about the crisis.

So what is the common story?

In think we have to go back to Milton Friedman’s Permanent Income Hypothesis (PIH). While at the Richmond Peter while at the Richmond fed in 1995 actually wrote about PIH and how it could be used for forecasting purposes. And one thing I noticed at all of Bob’s presentations in Copenhagen was how he returned to Irving Fisher and the determination of interests as a trade off between consumption today and in the future. Friedman and Fisher in my view are at the core of Bob’s and Peter’s thinking of the Great Recession.

So here is the Peter and Bob story: In 2007-8 the global economy was hit by a large negative supply shock in the form of higher oil prices. That pushed up US inflation and as a consequence US consumers reduced their expectations for their future income – or rather their Permanent Income. With the outlook for Permanent Income worsening interest rates should drop. However, as interest rates hit zero the Federal Reserve failed to ease monetary policy because it was unprepared for a world of zero interest rates. The Fed should of course more aggressively moved to a policy of monetary easing through an increase in the money base. The fed moved in that direction, but it was too late and too little and as a result monetary conditions tightened sharply particularly in late 2008 and during 2009. That can be described within a traditional monetarist framework as Bob do his excellent book “The Great Recession – policy failure or market failure” (on in his 2009 paper on the same topic) or within an intelligent New Keynesian framework as Peter do in his 2010 paper.

Peter uses the term a “New Keyensian Perspective” in his 2010. However, he does not make the mistakes many New Keynesians do. First, for all he realizes that low nominal interest rates is not easy monetary policy. Second, he do not assume that the central bank is always making the right decisions and finally he realizes that monetary policy is not out of ammunition when interest rates hit zero. Therefore, he might as well have called his paper a “New Friedmanite-Fisherian Perspective on the Great Recession”.

Anyway, try read Bob’s book (and his 2009 paper) and Peter’s paper(s). Then you will realize that Milton Friedman and Irving Fisher is all you need to understand this crisis and the way out of is.

I am finalizing this post after having arrived to my hotel in Provo, Utah and have had a night of sleeping – damn time difference. I look forward to some very interesting days at BYU, but I am not sure that I will have much time for blogging.

In my post on Zimbabwe’s so-called “coin problem” I came up with a possible solution:

“This might all seem like fantasy, but the fact remains that there today are around 500 million cell phones in Africa and there is 1 billion Africans. In the near future most Africans will own their own cell phone. This could lay the foundation for the formation of what would be a continent wide mobile telephone based Free Banking system.

Few Africans trust their governments and the quality of government institutions like central bankers is very weak. However, international companies like Coca Cola or the major international telecom companies are much more trusted. Therefore, it is much more likely that Africans in the future (probably a relatively near future) would trust money (or near-money) issued by international telecom companies – or Coca Cola for that matter.

In fact why not imagine a situation where Bitcoin merges with M-pesa so you get mobile telephone money backed by a quasi-commodity standard like the Bitcoin? I think most Africans readily would accept that money – at least their experience with government issued money has not exactly been so great.”

Guess what – the power of the market will never disappoint you. See this story:

“EcoCash, a mobile money-transfer service operated by telecommunications company EcoNet Wireless Zimbabwe, has reached a million subscribers in under six months since its launch, according to Mobile Money Africa. EcoCash enables money transfers across all networks between mobile users, a rapidly expanding sector of the Zimbabwean population.

And in a country where 80 percent of residents do not have access to mainstream bank accounts, a service that requires nothing but a mobile phone is a popular and more convenient alternative. Mobile phone users now make up 77 percent of the population, compared to just 6 percent in 2006, reports Mobile Money for the Unbanked. And EcoNet Wireless, EcoCash’s parent company, has that market cornered in Zimbabwe, with 6.5 million customers, which represents 70 percent of the market share of cell phone users, according to Mobile Money Africa….

….Within that segment, EcoCash has seen success by targeting the low-end market. Customers don’t need to have bank accounts, and 1,400 street agents throughout the country help make subscribing a quick and easy process. Agents receive a commission when customers total transactions reach $50, encouraging agents to target those likely to be actively using the service…

The ease of transactions is just one factor contributing to the skyrocketing popularity of EcoCash. Actual banks are more difficult to access than mobile phones, and the dark history of the Zimbabwean dollar contributed to widespread distrust of traditional banking services, reports the Zimbabwe Daily Mail.

…Visibility aids EcoCash in its market domination. EcoCash markets its services through advertisements on public mini-buses, known as kombis, in urban areas, and over radio talk shows in rural areas. Widespread marketing helps keep EcoCash ahead of other, smaller competitor. And while some competitors require users to have bank accounts, EcoCash allows customers to bank with just their phone.

…EcoCash modeled much of its strategy off of the success of Kenyan mobile money service M-Pesa, also under the umbrella of a telecommunications company,Safaricom. M-Pesa’s popularity has exploded in Kenya, with a customer base of close to 15 million subscribers, up from 2 million over five years.

Like EcoNet, M-Pesa’s parent company, Safaricom, dominates the telecommunications market in Kenya with a 67 percent market share, according to The Zimbabwe Independent. Like EcoCash, M-Pesa grew rapidly in its first year, although EcoCash’s first-year growth outpaced that of M-Pesa. And while Microfinance Africa reports that other countries have had difficulty replicating the long-term success of M-Pesa, similar marketing and business strategies and market domination make EcoCash a potential candidate to exhibit similar growth.”

Last week George Selgin warned us (the Market Monetarists) about getting to excited about the recent actions of the Federal Reserve. Now fellow Free Banker Larry White raises a similar critique in a post on freebanking.org.

Here is Larry:

“While saluting Sumner 2009…I favor an alternative view of 2012: the weak recovery today has more to do with difficulties of real adjustment. The nominal-problems-only diagnosis ignores real malinvestments during the housing boom that have permanently lowered our potential real GDP path. It also ignores the possibility that the “natural” rate of unemployment has been hiked by the extension of unemployment benefits. And it ignores the depressing effect of increased regime uncertainty.”

Larry’s point is certainly valid and Bill Woolsey has expressed a similar view:

“Targeting real variables is a potential disaster. Expansionary monetary policy seeking an unfeasible target for unemployment was the key error that generated the Great Inflation of the Seventies. Employment or the employment/population ratio could have the same disastrous result.”

I have already in an earlier post addressed these issues. I agree with Bill (and George Selgin) that it potentially could be a disaster for central banks to target real variables and that is also why I think that an NGDP level target is much preferable to the rule the fed now seems to try to implementing. Both Larry and George think that the continued weak real GDP growth and high unemployment in the US might to a large extent be a result of supply side problems rather than as a result of demand side problems. Eli Dourado makes a similar point in a recent thoughtful blog post. Bill Woolsey has a good reply to Eli.

To me our disagreement is not theoretical – the disagreement is empirical. I fully agree that it is hard to separate supply shocks from demand shocks and that is exactly why central banks should not target real variable. However, the question is now how big the risk isthat the fed is likely to ease monetary policy excessively at the moment.

In my view it is hard to find much evidence that there has been a major supply shock to the US economy. Had there been a negative supply shock then one would have expected inflation to have increased and one would certainly not have expected wage growth to slow. The fact is that both wage growth and inflation have slowed significantly over the past four years. This is also what the markets are telling us – just look at long-term bond yields. I would not argue that there has not been a negative supply shock – I think there has been. For example higher minimum wages and increased regulation have likely reduced aggregate supply in the US economy, but in my view the negative demand shock is much more import. I am less inclined to the Austrian misallocation hypothesis as empirically significant.

A simple way to try to illustrate demand shocks versus supply shocks is to compare the development in real GDP with the development in prices. If the US primarily has been hit by a negative supply shock then we would have expect that real GDP to have dropped (relative to the pre-crisis trend) and prices should have increased (relative to the pre-crisis trend). On the other hand a negative demand shock will lead to a drop in both prices and real GDP (relative to pre-crisis trend).

The next graph show the “price gap” which I define as the percentage difference between the actual price level and the pre-crisis trend.

Both graphs are clear – since the outbreak of the Great Recession in 2008 prices have grown slower than the pre-crisis trend (from 1993) and the price gap has therefore turned increasingly negative.

This in my view is a pretty clear indication that the demand shock “dominates” the possible supply shock.

Compare this with the early 1990s where prices grew faster than trend, while real GDP growth slowed. That was a clear negative supply shock.

That said, it is notable that the drop in prices (relative to the pre-crisis trend) has not been bigger when one compared it to how large the drop in real GDP has been, which could be an indication that White, Selgin and Dourado also have a point – there has probably also been some deterioration of the supply side of the US economy.

Monetary easing is still warranted

…but rules are more important than easing

Itherefore think that monetary easing is still warranted in the US and I am not overly worried about the recent actions of the Federal Reserve will lead to bubbles or sharply higher inflation.

However, I have long stressed that I find it significantly more important that the fed introduce a proper rule based monetary policy – preferably a NGDP level target – than monetary policy is eased in a discretionary fashion.

Therefore, if I had the choice between significant discretionary monetary easing on the one hand and NGDP level targeting from the present level of NGDP (rather than from the pre-crisis trend level) I would certainly prefer the later. Nothing has been more harmful than the last four years of discretionary monetary policy in the US and the euro zone. To me the most important thing is that monetary policy is not distorting the workings of the price system and distort relative prices. Here I have been greatly inspired by Larry and George.

I think we Market Monetarists should be grateful to George, Larry and Eli for challenging us. We should never forget that targeting real variables is a very dangerous strategy for monetary policy and we should never put the need for “stimulus” over the need for a strictly ruled based monetary policy. And again I don’t think the disagreement is over theory or objectives, but rather over empirical issues.

As our disagreement primarily is empirical it would be interesting to hear what George, Larry and Eli think about the euro zone in this regard? Here it to me seem completely without question that the problem is nominal rather than real (even though the euro zone certainly has significant supply side problems, but they are unrelated to the crisis).

This week I attended a presentation by my good friend and professor of political science at the University Copenhagen Peter Kurrild-Klitgaard about the upcoming US presidential elections. In his presentation Peter presented some of his models for predicting the outcome of US presidential elections.

Peter’s thesis is that what determines the US presidential election primarily is the economic situation in the US in the 8 quarters prior to the election. Peter’s models are inspired by Douglas Hibbs’ so-called “bread and peace” models.

If Peter is right – and I think he is – then the US president and his party will have an incentive to manipulate the business cycle to peak just prior to the elections. This is of course also is what inspired a large theoretical and empirical literature on the so-called political business cycles (PBC).

Most PBC models focus on fiscal policy. In William Nordhaus’ traditional PBC model the government would increase public spending and/or cut taxes prior to the elections and as Nordhaus assumed a traditional keynesian model of the world the government would hence be able to manipulate the business cycle.

The fact that Nordhaus assumed a rather naive keynesian model of the world obviously is also a big problem with the model and with the integration of rational expectations in macroeconomic models in 1980s and 1990s it also became increasingly clear that even though Nordhaus’ traditional PBC model is intuitively appealing it did not stand the test of time.

The biggest problem with the traditional PBC models, however, is they disregarded the importance of monetary policy. Hence, it might be that a government or a president can increase public spending prior to an election to try to get reelected, but how will the central bank react to that? Obviously if the central bank is under political control the government can just dictate to the central bank to play along and to ease monetary policy prior to the elections.

However, it is not given that the central bank is under the control of the government. In fact the central bank might even be hostile to the government and favour the opposition and in that case the central bank might actually itself be involved in manipulating the business cycle to achieve a certain political outcome which would be in contrast to what the government would like to see. In an earlier post I have described how the Bundesbank in the early 1990s punished the Helmut Kohl’s government for overly easy fiscal policy following the German reunification. This hardly helped Kohl’s government, but the Bundesbank was nonetheless unsuccessful in its indirect attempt to oust Kohl.

Did Bernanke just ensure Obama’s reelection?

During Peter’s presentation he highlighted that political prediction markets such – as the Iowa Electronic Markets – are better at predicting the outcome of US presidential elections than opinion polls. I certainly agree with Peter on this issue and therefore one of my first thoughts just after the FOMC announced it new policy action on September 13 was to think about how this influences Obama’s reelection chances.

If Peters models are right that higher real GDP growth increases the likelihood that Obama will be reelected and if I am right that I think Bernanke’s actions will likely spur real GDP growth in the short-run then the answer must be that Bernanke just helped Obama get reelected.

So what are the prediction markets saying? Well, there is no question that Obama’s election chances have increased significantly in recently. Political pundits talk about Michelle Obama’s speech at the Democrats’ convention or Romney’s not too elegant comments about Democrat voters. However, both Peter and I know that that is not really what is important. To us it is as James Carville used to say “It’s the economy, stupid”.

Just have a look at the market pricing of Obama’s reelection chances – this is data from intrade.com:

I think it is pretty clear – the Federal Reserve’s actions on September 13 have helped increase the likelihood of Obama getting reelected. Whether this is good or bad is a separate matter, but it certainly illustrates that if you want to be elected president in the US you want to have fed on your side.

This is not major news – for example former Fed chairman Arthur Burn’s rather scary account “Inside the Nixon Administration” – of his meetings with President Nixon shows that Nixon certainly was well-aware that the fed’s actions could do a lot to increase his reelection chances and that he put a lot of pressure on Burns to ease monetary policy prior to 1972 presidential elections (See my earlier post on Nixon and Burns here and Burton Abrams’ excellent discussion of the same topic here.)

This is of course also why you want to depoliticize monetary policy and get it as far away from political influence as possible – if politicians gets to control monetary policy the likelihood that they will misuse that power certainly is very high. Here the keyword is depoliticize – you in general don’t want central banks to interfere in politics for good or for bad. The central bank should just take fiscal policy as a given and respond to it only to the extent that it has an impact of it’s monetary policy target. That also includes that the central bank should not punish governments for bad policies either – as the ECB seem to be doing.

In the case of the present situation in the US it is therefore paradoxical that the Obama administration apparently has done so little to influence the decisions at the fed. So even though the Obama administration has appointed numerous Fed policy makers it does not look as if any attempt has been made to appoint Fed officials that would press for monetary easing – which obviously would have been in Obama’s interest (note this is an uneducated outsider’s guess…). This might be because the president’s main economic advisors are staunch keynesians who have little time for monetary policy matters. So if Obama is not reelected he might want to blame Larry Summers for past sins. It is equally a paradox that the fact that the Fed now seems to be moving in the direction of a more ruled based policy is what likely will help Obama get reelected.

Ideas for future research

When I started thinking about writing this blog post I actually started out with a research idea and I want to get back to that. One of the reasons that the literature on political business cycles has not produced any general conclusions or strong empirical results is in my view that models predictions are so dependent on what assumptions are made about the institutional set-up. Is the central bank for example independent or not? Will monetary policy counteract or accommodate pre-election spending?

I therefore think that there is scope for new research on particularly central bank’s institutional structures and how that might influence the political business cycle.

In the case of the US and the Federal Reserve I think it would be very interesting to study how different FOMC member’s partisan affiliations influence their voting during the election cycle. Would for example FOMC member appointed by the president vote for easier monetary policies prior to presidential elections? And will FOMC members from certain Fed districts vote in a way favorable to the dominant political affiliation of the given fed district?

I don’t know the answers to these questions, but I think it could be a rather interesting research project…

PS Peter’s model predicts that it will be 50/50 on who wins that presidential elections. If he is right then the present market pricing which clear favours Obama is wrong. Do you trust the models of a political scientist more than the market? I am sure that Peter would be on the side of the market…

PPS I should stress that I think that Bernanke and his colleagues with its latest actions have moved closer to a rule based monetary policy, which in itself should reduce the risk of political motivated monetary policy and I in general think that it is positive. That, however, does not change the fact that that might also have helped Obama. Whether that is a positive or negative side-effect dependents on your (party) political views and I luckily don’t have to have a view on who should win the US presidential elections…

PPPS Obviously the best way to avoid political business cycles is a strongly rule based monetary policy – such as NGDP level targeting, fixed exchange rates, a gold standard or free banking…some of these options I like better than others.

Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said the central bank should hold the main interest rate near zero until unemployment falls below 5.5 percent, marking the first time he has linked policy to a specific economic goal.

“As long as the FOMC is continuing to satisfy its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent,” Kocherlakota said today in the text of remarks prepared for a speech in Ironwood, Michigan, referring the policy-setting Federal Open Market Committee.

“My thinking has been greatly influenced by his,” Kocherlakota said, referring to Evans. “By increasing monetary accommodation, the Committee can better meet its employment mandate while still satisfying its price-stability mandate,” Kocherlakota said to business and community leaders at Gogebic Community College.

…”It’s an appropriate time to start thinking about when to begin the process of reversing the level of accommodation,” Kocherlakota said on May 9. “Six to nine months down the road, we should be thinking about initiating our exit strategy.”

Today, Kocherlakota said, “the FOMC can provide more current stimulus if people believe that liftoff will be triggered by a lower unemployment rate.”

Kocherlakota said today the central bank should give itself leeway by allowing inflation to deviate from its 2 percent target, saying the FOMC could contemplate raising rates if inflation rises above 2.25 percent. History suggests it’s unlikely inflation will rise above that point as long as the jobless rate remains above 5.5 percent, he said.

“The current economic impact of both forms of accommodation — low interest rates and asset purchases — depends on when the public believes that accommodation will be removed,” Kocherlakota said. Confident the Fed will keep the fed funds rate near zero until achieving 5.5 percent unemployment, “people will spend more today, and that will drive up economic activity,” he said.

This is pretty sensational – it seems like Kocherlakota finally understands. And it is it not only Kocherlakota. In fact it seems like there has been a completely transformation of the thinking at the Federal Reserve. I have no clue what happened at the Fed, but something happened. And it is good…

PS Just so it is 100% clear – I don’t think it is a good idea to target real variables like the unemployment rate and that it would make much more sense to introduce a proper NGDP level target, but at least variations of the Evans rules as suggested by Kocherlakota is much better than the status quo.

Even though George Selgin never said he was a Market Monetarists – he dislikes labels like that – he is awfully close to being a Market Monetarist and many of us are certainly Selginians. So when George speaks we all tend to listen.

Now George is telling us not to rest on our laurels after the Federal Reserve took “a giant leap” after it effectively announced an Evans style policy rule. I have called the Fed’s new rule the Bernanke-Evans rule. There is no doubt that the Market Monetarist bloggers welcomed fed’s latest policy announcement, but George is telling us not be carried away.

Here is George:

In the title of a recent post Scott Sumner jokingly wonders whether, having been credited by the press for badgering Ben Bernanke’s Fed until it at last cried “uncle!” by announcing QE3, he now needs to worry about going down in history as the guy who gave the U.S. its first episode of hyperinflation.

Well, probably not. But if Scott and the rest of the Market Monetarist gang don’t start changing their tune, they may well go down in history as the folks responsible for our next boom-bust cycle.

I’m saying that, not because, like some monetary hawks, I’m dead certain that no substantial part of today’s unemployment is truly cyclical in the crucial sense of being attributable to slack demand. I have my doubts about the matter, to be sure: I think it’s foolish, first of all, to assume that 8.1% must include at least a couple percentage points of cyclical unemployment just because it’s more than that much higher than the postwar average… Still, for for the sake of what I wish to say here, I’m happy to concede that some more QE, aimed at further elevating the level of nominal GDP to restore it to some higher long-run trend value to which the recession itself and overly tight monetary policy have so far prevented it from returning, might do some good.

But although QE3 is in that case something that might do some real good up to a point, it hardly follows that Market Monetarists should treat it as a vindication of their beliefs. On the contrary: if they aim to be truly faithful to those beliefs, they ought to find at least as much to condemn as to praise in the FOMC’s recent policy announcement. And yes, they should be worried–very worried–that if they don’t start condemning the bad parts people will blame them for the consequences. What’s more, they will be justified in doing so.

So what are the bad parts? Two of them in particular stand out. First, the announcement represents a clear move by the Fed toward a more heavy emphasis on employment or “jobs” targeting:

If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.

Yes, there’s that bit about fighting unemployment “in a context of price stability,” and yes, it’s all perfectly in accord with the Fed’s “dual mandate.” But monetarists have long condemned that mandate, and have done so for several good reasons, chief among which is the fact that it may simply be beyond the Fed’s power to achieve what some may regard as “full employment” if the causes of less-than-full employment are structural rather than monetary. The Fed should, according to this view, focus on targeting nominal values only, which can serve as direct indicators of whether money is or is not in short supply. Many old-fashioned monetarists favor a strict inflation target because they view inflation as such an indicator. Market Monetarists are I think quite right in favoring treating the level and growth rate of NGDP as better indicators. But the Fed, in insisting on treating the level of employment as an indicator of whether or not it should cease injecting base money into the economy, departs not only from Market Monetarism but from the broader monetarist lessons that were learned at such great cost during the 1970s. If Market Monetarists don’t start loudly declaring that employment targeting is a really dumb idea, they deserve at very least to get a Cease & Desist letter from counsel representing the estates of Milton Friedman and Anna Schwartz telling them, politely but nonetheless menacingly, that they had better quit infringing the Monetarist trademark.

So what is George saying? Well, it is really quite obvious. Monetary policy should focus on nominal targets – such a price level target or a NGDP level target – rather than on real target like an unemployment target (as the fed now is doing). This is George’s position and it is also the position of traditional monetarists and more important it has always been the position of Market Monetarists like Sumner, Beckworth and myself.

So just to make it completely clear….

…It is STUPID to target real variables such as the unemployment rate

There is no doubt of my position in that regard and that is also why I and other Market Monetarists are advocating NGDP level targeting. The central bank is fully in control the level of NGDP, but never real GDP or the level of unemployment.

With sticky prices and wages the central bank can likely reduce unemployment in the short run, but in the medium term the Phillips curve certainly is vertical and as a result monetary policy cannot permanently reduce the level of unemployment – supply side problems cannot be solved with demand side measures. That is very simple.

As a consequence I am also tremendously skeptical about the Federal Reserve’s so-called dual mandate. To quote myself:

” …I don’t think the Fed’s mandate is meaningful. The Fed should not try to maximize employment. In the long run employment is determined by factors completely outside of the Fed’s control. In the long run unemployment is determined by supply factors. In my view the only task of the Fed should be to ensure nominal stability and monetary neutrality (not distort relative prices) and the best way to do that is through a NGDP level target.”

Is the glass half empty or half full?

It is clear that it has never been a Market Monetarists position to advocate that the Fed or any other central bank should target labour market conditions, but this is really a question about whether the glass is half full or half empty. George is arguing that the glass is half empty, while his Market Monetarist pals argue it is half full.

The reasons why the Market Monetarists are arguing the glass is half full are the following:

1) The fed has become much more clear on what it wants to achieve with its monetary policy actions – we nearly got a rule. One can debate the rule, but it is certainly better than nothing and it will do a lot to stabilise and guide market expectations going forward. That will also make fed policy much less discretionary. Victory number one for the Market Monetarists!

2) The fed has become much more clear on its monetary policy instrument – it is a about increasing (or decreasing) the money base by buying Mortgage Backed Securities (MBS). To Market Monetarists it is not really important what you buy to increase the money base – the point is the monetary policy is conducted though changes in the money base rather than through changes in interest rates. This I think is another major monetarist victory!

3) The fed’s policy actions will be open-ended – the focus will no long be on how much QE the fed will do, but on what it will do and the fed will – if it follows through on its promises – do whatever it takes to fulfill its policy target. Victory number three!

It is certainly not perfect, but it certainly is a major change compared to how the fed has conducted monetary policy over the past four years. We can of course not know whether the fed will change direction tomorrow or in a month or in a year, but we are certainly heading in the right direction. I am sure that George would agree that these three points are steps in the right direction.

But lets get to the “half empty” part – the fed’s new unemployment target. George certainly worries about it as do I and other Market Monetarists. Bill Woolsey makes this point very clear in a recent blog post. However, I think there is an empirical difference in how George see the US economy and how most Market Monetarists see it. In George’s view it is not given that the present level of unemployment in the US primarily is a result of demand side factors. On the other hand while most Market Monetarists acknowledge that part of the rise in US unemployment is due to supply side factors such as higher minimum wages we also strongly believe that the rise in unemployment has been caused by a contraction in aggregate demand. As a consequence we are less worried that the fed’s new unemployment target will cause problems in the short to medium term in the US.

In that regard it should be noted that the so-called Evans rule mean that the fed will ease monetary policy until US unemployment drops below 7% or PCE core inflation increases above 3%. Fundamentally I think that is quite a conservative policy. In fact one could even argue that that will not be nearly enough to bring NGDP back to a level which in anyway is comparable to the pre-crisis trend.

We should listen to our pal George and continue advocacy of NGDP level targeting

The fact that I personally is not overly worried about a conservative Evans rule (7%/3%) will lead to a new boom-bust as George seem to suggest does, however, not mean that we should stop our advocacy. While we seem to have won first round we should make sure to win the next round as well.

It is therefore obvious that we should continue to strongly advocate NGDP level targeting and we should certainly also warn against the potential dangers of unemployment targeting.

Finally I would also argue that Market Monetarists should step up our campaign against moral hazard. There is no doubt the failed monetary policies over the past four years have led to an unprecedented increase in explicit and implicit government guarantees to banks and other nations. These guarantees obviously should be scaled back as fast as possible. A rule based monetary policy is the best policy to avoid that the scaling back of such too-big-to-fail procedures will lead to unwarranted financial distress. This should do a lot to ease George’s fears of another boom-bust episode playing out as the US and the global economy start to recover. (See also my earlier post on moral hazard and the risk of boom-bust here.)

Similarly if we are so lucky that the fed’s new policy set-up will be start of the end of the slump then Market Monetarists should be as eager to fight excessive monetary easing as we have been in fighting overly tight monetary policy. In that regard I would argue that I personally have a pretty solid track record as I was extremely critical about what I saw as overly easy monetary policy in the years just prior to the crisis hit in 2007-8 in countries like Iceland and the Central and Eastern European countries.

So George, there is no reason to worry – we don’t trust the fed more than you do…

PS I stole (paraphrased) my headline from one of George’s Facebook updates.

Update: Scott Sumner also comments on George’s post and George has a reply.

It is rather seldom we get worldclass economists to Copenhagen, but in the coming week that is going to change as Robert Hetzel is in town. The Danish free market think tank Cepos has invited Bob to speak a seminar tomorrow (Monday) night. I will certainly make sure to be there!

Bob will be in Copenhagen a couple of days and it is also planned that Bob will speak at seminars at the Danish central bank as well as at the University of Copenhagen.

I guess that most of my readers are familiar with who Bob Hetzel is, but for the rest of you I just need to say that I think that Bob is one of the foremost monetary specialists in the world today and Bob is of course the author of the greatest book on the present crisis – “The Great Recession: Market Failure or Policy Failure?”

Sometimes simple macroeconomic models can help us understand the world better and even though I am not uncritical about the IS/LM model it nonetheless has some interesting features which from time to time makes it useful for policy analysis (if you are careful).

However, a key problem with the IS/LM model is that the model does not take into account – in its basic textbook form – the central bank’s policy rule. However, it is easy to expand the model to include a monetary policy rule.

I will do exactly that in this post and I will use the Federal Reserve’s new policy rule – the Bernanke-Evans rule – to analysis the impact of the so-called fiscal cliff on a (very!) stylised version of the US economy.

We start out with the two standard equations in the IS/LM model.

The money demand function:

(1) m=p+y-α×r

Where m is the money supply/demand, p is prices and y is real GDP. r is the interest rate and α is a coefficient.

Aggregate demand is defined as follows:

(2) y=g-β×r

Aggregate demand y equals public spending and private sector demand (β×r), which is a function of the interest rate r. β is a coefficient. It is assumed that private demand drops when the interest rate increases.

This is basically all you need in the textbook IS/LM model. However, we also need to define a monetary policy rule to be able to say something about the real world.

I will use a stylised version of the Bernanke-Evans rule based on the latest policy announcement from the Fed’s FOMC. The FOMC at it latest meeting argued that it basically would continue to expand the money base (in the IS/LM the money base and the money supply is the same thing) to hit a certain target for the unemployment rate. That means that we can define a simple Bernanke-Evans rule as follows:

(3) m=λ×U

One can think of U as either the unemployment rate or the deviation of the unemployment rate from the Fed’s unemployment target. λ is a coefficient that tells you how aggressive the fed will increase the money supply (m) if U increases.

We now need to model how the labour market works. We simply assume Okun’s law holds (we could also have used a simple production function):

(4) U=-δ×y

This obviously is very simplified as we totally disregard supply side issues on the labour market. However, we are not interested in using this model for analysis of such factors.

It is easy to solve the model. We get the LM curve from (1), (3) and (4):

LM: r= y×(1+δ×λ)⁄α+(1/α)×p

And we get the IS curve by rearranging (2):

IS: r =(1/β)×g-(1/β)×y

Under normal assumptions about the coefficients in the model the LM curve is upward sloping and the IS curve is downward sloping. This is as in the textbook version.

Note, however, that the slope of the LM does not only depend on the money demand’s interest rate elasticity (α), but also on how aggressive (λ) the fed will react to an increase in unemployment.

The Sumner Critique applies if λ=∞

The fact that the slope of the LM curve depends on λ is critical. Hence, if the fed is fully committed to its unemployment target and will do everything to fulfill (as the FOMC signaled when it said it would step up QE until it hit its target) then λ equals infinity (∞) .

Obviously, if λ=∞ then the LM curve is vertical – as in the “monetarist” case in the textbook version of the IS/LM model. However, contrary to the “normal” the LM curve we don’t need α to be zero to ensure a vertical LM curve.

Hence, under a strict Bernanke-Evans rule where the fed will not accept any diviation from its unemployment target (λ=∞) the (government) budget multiplier is zero and the so-called Sumner Critique therefore applies: Fiscal policy cannot increase or decrease output (y) or the unemployment (U) as any fiscal “shock” (higher or lower g) will be fully offset by the fed’s actions.

The Bernanke-Evans rule reduces risks from the fiscal cliff

It follows that if the fed actually follows through on it commitment to hit its (still fuzzy) unemployment target then in the simple model outlined above the risk from a negative shock to demand from the so-called fiscal cliff is reduced greatly.

This is good news, but it is also a natural experiment of the Sumner Critique. Imagine that we indeed get a 4% of GDP tightening of fiscal policy next year, but at the same time the fed is 100% committed to hitting it unemployment target (that unemployment should drop) then if unemployment then increases anyway then Scott Sumner (and myself) is wrong – or the fed didn’t do it job well enough. Both are obviously very likely…

I am arguing that I believe the model presented above is the correct model of the US economy. The purpose has rather been to demonstrate the critical importance of a the monetary policy rule even in a standard textbook keynesian model and to demonstrate that fiscal policy is much less important than normally assumed by keynesians if we take the monetary policy rule into account.